How adding back building depreciation works

If you purchased a property after May 13, 1997, then any building depreciation you were entitled to claim while it was earning income must reduce the cost base from which you calculate your capital gains tax (CGT) when you sell. Here’s how it works:

Claiming building depreciation

Building depreciation is central to the benefits of negative gearing. It allows you to claim a tax deduction each year for 1/40th of the original cost of the building or renovation. The tax deduction doesn’t require any cash outflow like other expenses do and it provides cash inflow from the tax refund it generates. Note, it’s based on the original building cost – not the price you paid for the property – and it doesn’t include the cost of land or landscaping.

If you don’t know the original building costs you might be able to obtain them from the body corporate or the person who sold you the property. In fact they’re required to provide you with that information if they’d been using the property as a rental. If and only if you can’t obtain the original building costs by other means, you’re allowed to have them estimated by a quantity surveyor.

Calculating the Capital Gain

When you sell a property that isn’t fully covered by your main residence exemption, you’ll be liable for CGT on the difference between the selling price and your cost base.

Your cost base is made up of the original price you paid for the property or its market value when it was first rented out, if it was covered by your main residence exemption up until then. Add to this any other costs associated with the property that you haven’t otherwise been able to claim a tax deduction for.

When the cost base is reset to market value, you can only increase it by expenses incurred after that date such as selling costs. If there’s no reset then go right back to the start and include purchasing costs such as stamp duty and solicitor’s fees.

If you’ve used the property for private purposes, you wouldn’t have been able to claim a tax deduction for normal holding costs such as interest, rates, cleaning, repairs etc. during that time, so these can also be included in your cost base, unless they’re incurred before the cost base is reset.

You then reduce this amount by any building depreciation that you were entitled to claim while it was earning income. The difference between this cost base and the selling price is your capital gain – usually this is halved for the 50 per cent CGT discount – and added to your other taxable income to be taxed at your normal tax rate.

It’s because of this 50 per cent discount on capital gains that, except in some unusual circumstances, it’s still better to claim the depreciation during the time the property is rented. Effectively only 50 per cent is going to be written back when you sell. An example of an unusual circumstance is if you weren’t taxable during the period the property was held as a rental but made such a large capital gain that you were taxable in the year that it sold. You don’t really have a choice.

It isn’t a case of whether you’ve had the benefit of claiming the tax deduction for the depreciation. The law is clear – if you were entitled to claim a tax deduction then you must reduce your cost base, whether you claimed it or not. The Australian Taxation Office (ATO) has made some concessions to a strict interpretation of the law but of course it could change its mind at any stage, so you may as well take the tax deduction while you can.

If you’re about to sell a property that you haven’t claimed building depreciation for, you need to consider fitting within these rulings. Practice Statement Law Administration (PSLA) 2006/1states that, providing the only way you can find out the original building costs is to employ a quantity surveyor and you have never actually claimed building depreciation, you don’t have to add back the notional depreciation that you could have claimed. Note, the ruling talks about trying to contact the previous owner for information. All other methods of obtaining the original building costs must be exhausted.

Taxation Determination (TD) 2005/47 looks at the situation where you may even know the original construction costs or have a quantity surveyor’s report but haven’t ever claimed depreciation. You’ll only be required to reduce your cost base for the past four years because you can only amend your tax return back four years to claim the building depreciation. As they’re the only years that you’re now entitled to a deduction, they’re the only ones that will reduce the cost base. This is great because it also means you can go back and claim the depreciation you’ve missed out on.

Plant and equipment

I haven’t mentioned plant and equipment, such as carpets, stoves and hot water systems, because they’re not subject to CGT. The value of the plant and equipment is deducted from the original purchase price or market value reset before it’s included in the CGT calculation.

Likewise the market value of the plant and equipment is removed from selling price. The ATO usually accepts that you reduce the purchase price or reset value by the opening values for your plant and equipment depreciation schedule and the selling price by the closing values from this schedule.